Difficulties in Forecasting Borrowing Requirements

We’ve long known that governments have a difficult time forecasting their own borrowing needs, demonstrating–like most of us–an inability to face up to the reality of their financial positions, particularly when it’s getting worse.

That’s why economists and other interested observers have often looked to international agencies such as the European Commission and the Organization for Economic Cooperation and Development for a reality check, and less deluded assessments of the spending propensities and revenue-generating potential of various governments.

But recently published research suggests that reliance on international agencies may itself be deluded, since they suffer from many of the same failings as national governments: in seeking “inside” information on how budgets are evolving, EC and OECD economists make themselves susceptible to the “political bias” of the government they are assessing.

In a paper published by the European Journal of Political Economy, Rossana Merola of Ireland’s Economic and Social Research Institute, and Javier Perez of the Bank of Spain examined the track record of the EC, the OECD and 15 European governments in forecasting budget deficits over the years 1999-2007.

By choosing that period, they exclude the years of turmoil that followed the financial crisis, when an unprecedented sequence of events meant that almost everyone got everything wrong all of the time. Sure enough, they found that government forecasts were well off the mark, and were wrong in a fairly predictable way: when elections were looming, they tended to be significantly more optimistic than was warranted. What governments appear to do is ignore the implications of slowdowns in economic growth for tax revenues, consistently believing they will be higher than they turn out to be.

But they found that the forecasts produced by international agencies are not immune to political bias, concluding that they also “display correlation with electoral cycles.”

It’s not clear why that should be so. As the authors note, governments and international bodies produce forecasts in slightly different ways. Because they have more real-time information on spending and revenues, governments tend to forecast from the bottom up, basically adding up all the costs of running various departments, and the revenues produced by specific taxes.

By necessity, the forecasts produced by international agencies tend to be more top down, based largely on forecasts for economic growth, its composition, and the historic relationship between those elements and tax revenues.

It’s worth remembering that governments are essentially shareholders in international agencies, and that no such agency produces a forecast for growth or borrowing without first discussing it with the government in question. So there is an opportunity for lobbying and persuasion.

“Governments can influence forecasts prepared by international organizations, as national countries are shareholders of these organizations and thus have the possibility to know those forecasts in advance and discuss them with the staff of the relevant organization,” the authors wrote.

There is some potential benefit for international agencies in holding those discussions, since they can gain access to the “private information” governments have about exactly how tax revenues are holding up in the face of economic slowdowns, or other developments. In the process, however, economists at those international agencies can end up adopting some of the unwarranted optimism common among government officials, perhaps unknowingly.

“When preparing fiscal projections, international agencies’ staff try to grasp as much private information as possible from government’s forecasts, while at the same time face a “signal extraction problem” when trying to disentangle “political biases” from genuine private information,” the two economists wrote.

A spokesman for the OECD said it is preparing its own paper on the reliability of economic forecasts, which it hopes to release in coming weeks.

Simon O’Conner, spokesman for Vice-President of the European Commission Olli Rehn, stated “the Commission’s economic forecasts are produced independently of national capitals, by teams of experts with in-depth knowledge of the countries concerned. They maintain close contacts with all relevant national authorities, but also independent experts.” He added that between 2010 and 2013, the EU’s economic governance procedures were substantially overhauled.

So who can we trust? The two economists argue that their findings speak in favor of independent national forecasters, such as the Office for Budget Responsibility in the U.K., which would have access to “private infomration” but be explicitly shielded from political bias. But it will take many years before it is clear whether a new wave of organizations such as the OBR are truly immune from the influence of the electoral cycle.

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